The Hindu Business Line : The impact of inflation

Santosh thinks he has his investment plans sewn up. He'd like to move into a three-bedroom apartment in five years and also save up enough to put his four-year-old son through an MBA degree 15 years hence. He reckons he needs to save up Rs 65 lakh (today, the apartment costs Rs 45 lakh and an MBA degree Rs 20 lakh). But proceeding on this premise could well land him in financial soup!

This is because he has neglected to factor in the impact of price rise or "inflation" into his calculations. Assuming prices rise by 5 per cent a year, the apartment would cost Rs 57.4 lakh and the college degree a whopping Rs 41.5 lakh, when it is time to spend. What Santosh needs to save up, therefore, is actually nearly a crore of rupees!

The above example illustrates just one of the ways in which inflation impacts your financial decisions. There are several others. One, the longer the time horizon, higher the impact of inflation on your outlay. Two, inflation steadily gnaws at your effective returns. If you think your bank deposits are yielding a princely return of 8 per cent a year, remember that you give up about 5-7 per cent of that to inflation. Your `real' returns, that is, the rate at which your money is actually growing would be just 1-3 per cent a year. Therefore, a focus on `real' returns and inflation has a bearing on every aspect of your financial plan.

Okay, you are convinced; but how do you go about factoring in inflation into your calculations? Several financial Web sites feature a readymade "inflation calculator" that computes the future value of any investment made today, assuming a steady inflation rate.

So what inflation rate should you assume? Inflation in India is usually measured through two popular gauges — the Wholesale Price Index (WPI) and the Consumer Price Index (CPI) — both of which are indices capturing the price rise in a specific basket of goods. The government's periodic releases on the inflation rate (usually cited in per cent, year-on-year) are published in the financial dailies. From an investors' standpoint, the CPI may be a more relevant gauge of prevailing inflation levels than the WPI, because it reflects prices at the consumer level. (Latest statistics show that the prevailing annual rate of CPI inflation is 7.2 per cent, while WPI inflation is about 5 per cent).

However, do remember that the official numbers only give you a rough indication of the inflation rate that you may have to factor into your long-term plans. For better results, you should adjust this number to reflect the expected price rise in the asset you plan to acquire. For instance, property prices have tended to rise far more rapidly than the prices of gold over a 10-year period; this calls for a higher inflation factor when you plan to buy property than when you buy gold.

Location and time horizon may also influence your inflation assumptions. But do not worry too much about whether you've accurately predicted inflation in your financial plans. Factoring in a reasonable inflation rate into your calculations will in itself ensure that your investments are not way out of sync with the requirements, when the time comes to spend that money.